By Tom Bradley

The discipline of writing 800-900 words for the Globe and Mail every two weeks means that stuff gets left on the cutting room floor. But as I’m learning, that’s usually where it belongs.

Having said that, I did want to add an addendum to my last installment about reaching for yield (Don't Let Your Search for Yield Blind You to Risk). A big part of the income product proliferation over the last few years has come in the form of funds or products that offer a set distribution rate, which is usually paid monthly. Every self-respecting institution now offers a monthly income fund and many offer a T-series version of their mutual funds (which have set distribution levels).

In some cases, the distribution rates are set to reflect the income level of the fund – interest and dividends minus management fees and expenses. But increasingly, the yield is based on the expected ‘total’ return of the fund (interest, dividends and long-term capital gains).

These funds can be a convenient way to receive a pay cheque when in retirement, but there are a few things to be aware of:

  • Distributions are not guaranteed. If the income potential and outlook for the fund changes, the rate could be adjusted. Hopefully the long-term return exceeds the distribution rate, but if it doesn’t, one of two things will happen. Either the distributions will be cut or they’ll be paid out of capital...your capital.
  • Death and taxes. There are tax features to some of these products. In certain scenarios there is a deferral or arbitrage benefit, but don’t kid yourself – a return of your capital is tax efficient because it’s your ‘after-tax’ money being returned to you.
  • Balanced funds in disguise. These funds are essentially conservative balanced funds, so they will fluctuate in price along with their underlying securities. In a 3-4% interest rate world, it’s reasonable to expect long-term returns of 5-6%. In that context, a product with a distribution rate above 4% per year needs markets to go up and fees to be reasonable to avoid dipping into capital.
  • No escaping path dependency. It’s important to know that no matter what the long-term returns turn out to be, it’s better when the fund zigs up before it zags down. When the zag comes first, securities have to be sold at reduced prices to fund the distributions and less capital is available to earn back the losses. If a market downturn lasts for a couple of years and distributions are maintained, then the fund may be seriously depleted by the time the recovery comes.
  • Cash flow management on auto-pilot. Packaged income products definitely are convenient, but they don’t negate the fact that you still need to manage your cash flows – e.g. have some cash and short-term investments available to pay the bills when markets are down and you don’t want to sell your longer-term investments.

Essentially, packaged income products with set distributions are no different than making withdrawals from a balanced portfolio. In both cases, it means that the higher the promised yield, the more you have to understand the product. The higher the yield, the more ‘reaching’ being done. And the higher the yield, the more volatile they’ll be.